The path to Brexit

In response to the result of the EU referendum in June 2016, the prime minister, Theresa May, has announced that the UK will leave the single market and potentially the customs union as well. Being able to strike external trade deals is a key part of the government's Brexit strategy.

Outside of the customs union the UK government is likely to pursue a trade deal with the EU. However, completing this before it formally withdraws in early 2019 will be difficult.

The government will try to conduct trade talks while negotiating the terms of exit; agreeing an implementation phase for a future UK-EU deal will be important.

We expect the government to negotiate sector-specific arrangements, particularly for sectors such as automotives and agriculture, for which the EU market is critical. The UK's financial services sector is likely to be undermined by a loss of passporting rights, but will retain a strong international presence.

There will be a number of obstacles on the path to Brexit, including the risk of a breakdown in talks or a rejection of the final deal. When the UK leaves the EU in 2019 formal trade negotiations with other countries will begin, but these may take years.

We expect the government to focus on boosting the UK's international competitiveness and tackling the economy's structural weaknesses with greater urgency.

Mrs May stated soon after the Brexit vote that control over immigration and ending the jurisdiction of the European Court of Justice would be priorities for the UK in redefining its trading relationship with the EU. Both are incompatible with membership of the EU's single market, and rather than engage in protracted negotiations on this point to reach a compromise that would keep the UK in the single market, Mrs May announced in a speech on January 17th that the UK would relinquish its membership, but negotiate the fullest possible access to the trading area as a non-member.

Plans to strike third-party trade deals

Mrs May has said that she would like the UK to have tariff-free access to EU markets, but full customs union membership—which allows goods to move freely without customs checks—would mean a common external tariff and, crucially, would prevent the UK from negotiating trade deals with other countries. The latter is a key part of the government's plan to make a success of Brexit. Much of the prime minister's rhetoric has focused on the desire to look beyond Europe and become a global trading nation. Mrs May has started to lay the groundwork for trade talks during recent visits to India and New Zealand, and will soon meet with the US president, Donald Trump, to discuss a UK-US trade deal. Liam Fox, the UK's international trade secretary, has told the press that informal talks with "dozens of countries" are already under way.

The UK's departure from the EU customs union is a strong possibility. An alternative option to full membership of the customs union would be a customs agreement with the EU, implying some kind of partial or associate membership that allows the UK to strike free-trade agreements (FTAs) with third parties. In our view, however, the chances of negotiating such an arrangement are slim. If the government leaves the customs union, it is likely to pursue a bilateral trade agreement with the EU.

Reaching a UK-EU deal will be an ambitious task

By withdrawing from the single market the UK will not be asking EU leaders to compromise on the four fundamental freedoms, thereby removing what would have been the most contentious area of negotiations. As a result, the talks have the potential to be less protracted than we previously assumed. However, establishing the basic framework of a trade deal with the EU by the end of the two-year window for negotiations—as outlined in Article 50 of the Lisbon treaty—will still be very difficult. The government will invoke Article 50 by the end of the first quarter of this year, giving it until early 2019 to negotiate its exit arrangement from the EU.

Whether the UK will also have an FTA drawn up by this point will depend on whether it can negotiate an exit agreement and a trade deal simultaneously. Some in Europe have objected to allowing exit and trade talks to run in parallel. However, the UK government will want to establish early on—probably in its Article 50 letter—that this can happen and that there will also be an "implementation phase" for the deal after the UK formally withdraws from the EU. Downside risks to this timeline are high, particularly given capacity constraints on both sides. FTAs typically take five years or longer from launch to implementation, and increase in complexity the closer the desired trading relationship.

However, there are reasons to believe that the government will be able to reach a deal with the EU within the desired timeframe. First, the timescale for FTAs usually includes an implementation phase, which lasts for a few years. David Davis, the minister for exiting the EU, has said that this phase should last around one to two years, although some banks have called for it to last three to five years. Second, much of the time spent in FTA negotiations is usually spent on how both sides will harmonise product regulations, but these are already the same for the UK and the EU. Third, because existing trading arrangements are being dismantled rather than new ones being established, a "cliff-edge" point at which the current relationship ends would be damaging to the EU as well as the UK, giving both sides an incentive to expedite the process and avoid this.

The timescale will also depend on how comprehensive the FTA is. Access to the single market may be limited by domestic pressure to roll back EU product regulations and minimise contributions to the EU budget. However, the prospect of trade barriers, including rules of origin, tariffs on some goods and checks for compliance with EU standards, is likely to be a sufficient economic incentive to ensure that UK sectors with the closest ties to the EU market can maintain them at a low cost.

In 2015 the average tariff imposed by the EU on all products was 4.8%, and 3.9% on non-agricultural products. Tariffs on goods vary by sector, but many UK industries will lobby for low or no tariffs. We expect a special arrangement to be negotiated for the automotive industry, which sells almost 60% of its vehicle exports to Europe. UK producers of cars want to avoid EU tariffs on car imports of around 10%, as well as significant disruption to their supply chains, which are highly integrated with Europe. Other sectors with an interest in securing favourable arrangements under the FTA include chemicals and manufactured goods, which both sell more than 50% of their exports to the EU, and the UK's mineral fuels industry, for which this share is around 77%.

The arrangements made for the UK's agricultural sector will be particularly important. EU agricultural tariffs are high, at 10.9% on average in 2015, and it is unlikely that the sector will be able to retain support from the EU's Common Agricultural Policy (CAP). Currently, 50‑60% of UK farmers' income is derived from CAP subsidies and the UK government may struggle to replace them in full.

The UK will seek to secure special provisions for the financial services sector, but may not be successful. Services tend not to be covered in FTAs, and outside of the single market the UK's financial services firms are almost certain to lose passporting rights that allow them to operate in EU member states. Even if regulatory equivalence is established, the loss of passporting will undermine the position of London as Europe's financial centre where, for example, US and Swiss banks have set up in order to gain access to EU markets. However, the capital should retain its status as a pre-eminent international financial centre by virtue of language, time zone and an existing concentration of interconnected businesses. It may even gain a competitive edge through its ability to repeal some EU regulations.

Whatever the new trading arrangement, UK-EU ties are likely to remain close. Mrs May expressed a desire to participate in specific European programmes, for example in the education sector, which would require a small contribution to the EU budget. Moreover, given the security challenges faced by the region, both sides have a strong incentive to continue co-operating in areas of defence and intelligence.

Practical difficulties and downside risks

There will be a number of obstacles on this path to Brexit. As was the case with the EU's recently completed trade agreement with Canada, there is a risk that a single member state (or in that case a regional parliament) could block a future deal between the EU and the UK. Both houses of the UK's parliament will also vote to approve the EU deal before it is ratified. We think it is highly unlikely that the House of Commons or the House of Lords would reject it, particularly as this would mean leaving the EU with no deal in place.

Political exigencies on both sides are likely to reduce the scope for an amicable divorce, and negotiations may fail before a deal is reached. Mrs May has also made it clear that no deal is better than a bad deal and that the UK is prepared to trade with the EU on World Trade Organisation (WTO) terms. If no extension of the Article 50 deadline is agreed by all 27 EU members, the UK would leave the EU in 2019 and revert to WTO trade rules. Even if this scenario can be avoided, the UK still needs to negotiate its own tariff schedule with the WTO's 163 members, although it may negotiate to inherit the EU's schedule for a short period.

There is also the issue that the UK's withdrawal from the EU in 2019 will end its participation in trade agreements that the bloc holds with around 50 partners, and only then can formal negotiations on third-party trade deals start. We expect this to lead to a modest slowdown in export sales from 2019. Although some of the groundwork is being done, FTAs with other countries will take years to be established. In the meantime, there will be a more urgent focus on the domestic agenda, with the UK government seeking to address the economy's structural deficiencies and boost its international competitiveness.